What is alternative beta?

The term “alternative beta” was first coined by Professors Bill Fung and David Hsieh in their excellent 2003 paper, “The risk in hedge fund strategies: alternative alphas and alternative betas.” Most of the academic research on this subject, however, has taken place in the last year or two, with another key paper, “Factor modelling and benchmarking of hedge funds: can passive investments in hedge fund strategies deliver?” published by Dr Lars Jaeger and Christian Wagner of Partners Group in November 2005.

“Alternative beta” are the common “risk factors” which, at an aggregate level, explain most of variability in hedge fund performance.

Fixed income hedge funds, for example, perform best when credit spreads and convertible bond spreads contract. Long-short equity funds tend to do well when small companies outperform large. Managed futures strategies perform best in trending markets. In each of these cases, performance depends not just on manager skill, but also on systematic exposure to “alternative beta” risk factors.

At present, there is no consensus definition of alpha, although many experts now define alpha to be return which cannot be systematically manufactured. Academic papers are therefore moving towards a description of hedge fund returns, broadly as follows:

Hedge fund return = Traditional beta + Alternative beta + Alpha

Where “alternative beta” refers to the return derived from exposure to systematic risk factors (such as credit risk, liquidity risk, volatility risk, small company risk) common to each family of hedge fund strategies, and “alpha” is simply the additional return stemming from the unique ability and skill set of the manager.

Recent academic analysis suggests that only a small fraction of hedge fund returns is actually accounted for by alpha. The main sources of returns are the risk premia derived from a diverse array of “alternative beta” factors. This insight is gradually spreading amongst the more sophisticated hedge fund investors, and is set to revolutionise the way that investors think about hedge funds.